Wealthy older clients from high-tax states often will consider moving to a lower-tax state to save money. These moves typically relate to state income taxes on retirement benefits and state estate taxes on clients’ net worth or gross estate.
You may have heard certain people say, “If I live for more than 180 days in a particular state, then I will have successfully changed my residence for state tax purposes.” This statement has a small degree of truth to it, but it is short-sighted and far from accurate.
First, let’s have a brief discussion about state income taxes on retirement benefits. Then, let’s talk about state estate taxes on a gross estate. Finally, we’ll explore the many hurdles to overcome when your client thinks about changing legal residency.
State Income Taxes on Retirement Benefits
Before 1996, certain states would aggressively seek former residents to tax their retirement income benefits in the state where the individuals lived during their working careers. In 1996, this state practice was dealt a significant roadblock when “source tax” relief was passed by the U.S. Congress and signed into law by President Bill Clinton.
This federal law (Title 4 United States Code, Chapter 4, Section 114) prevents states from taxing former residents on all distributions received from any qualified retirement plans after they become legal residents of another state. Of course, the key phrase is “legal resident.” It makes no difference whether the distribution is in a lump sum or a series of payments over the life of the participant. Only the state of legal residency will be able to levy state income tax, if any, on qualified plan distributions.
Before this anti-source tax law, certain states such as New York and California imposed income taxes on qualified plan benefits based on a “source” theory of taxation. For example, someone might spend their working life in New York (a state with a high personal income tax rate) and retire to Florida (a state with no personal income tax). Or someone might have worked in California (which has a high personal income tax rate) and retired to Nevada (which has no personal income tax).
In fact, New York, California and other high-income-tax states had carried out an active campaign to tax qualified plan benefits when received by former residents. The tax collection tactics of these high-tax “source” theory states were rendered illegal by Title 4 USC, Chapter 4, Section 114, which prohibits taxing nonresidents on qualified plan income.
Qualified retirement income is defined as distributions from employer-provided pension plans under Internal Revenue Code Section 401 (defined benefit, profit sharing and 401(k) plans), simplified employee pensions (SEP) under IRC Section 408(k), tax-sheltered annuities under IRC Section 403(b), individual retirement accounts under IRC Section 408, and IRC Section 457(b) “eligible” plans for nonprofit or government employees.
In summary, the key question is, did the individual actually become a legal resident of the new state? We’ll explore some of the requirements to become a legal resident shortly.
State Estate Taxes at Death
The second major state tax that may affect certain individuals is found in those states that levy estate taxes upon the death of a legal resident. About 20 states tax the gross estate of an individual at death. Many of these states are found in the northeastern part of the U.S. Generally, the tax rates progressively range from about 6 percent to 16 percent, with a variety of state exemptions.
For estates over $10 million, the maximum rate on the excess ranges from 12 percent to 16 percent, depending on the state. There is a federal estate tax deduction for any state estate taxes actually paid. Again, the state of legal residency is the key question that determines whether an individual will be subject to state estate taxes.
Based on state income taxes and state estate taxes alone, certain individuals and couples often decide that it would be in their best interest to move permanently to a state with lower taxation. States that have both zero income taxes on retirement benefits and zero estate taxes would be particularly favored as choices for permanent residency. These states include Florida, Texas, Nevada, New Hampshire, Alaska, South Dakota and Wyoming.
Note No. 1: New York and Maryland are in the process of phasing in an increase in their state death-tax exemptions over the next few years. Eventually, the New York and Maryland exemptions will be equal to the federal estate-tax exemption by 2019.
Note No. 2: Keep in mind that any real estate your client owns in their former state will still be subject to estate taxes in that state upon your client’s death. Rental income and capital gains upon any subsequent sale of the property will be subject to income and capital gains taxes in that former state as well.
Changing State of Residency
Now that we have summarized state income taxes on retirement benefits and state estate taxes at death, let’s look at how to determine that an individual has actually become a “legal” resident of a new state. If your client has not become a “legal” resident of a new state, then the former state would still have the possibility of taxing retirement benefits during lifetime and levying estate taxes at death.
Changing residency is not as easy as you may think. Many states impose a subjective test that looks at an individual’s connections to each state to determine residency. What are some of the steps that must be taken to sever ties with the old state and establish strong connections with the new state to document a change of residency?
Many states determine tax residency by looking at a person’s domicile or the place where the individual has the closest connections. As a subjective test, state courts and tax authorities will consider many factors to determine residency for tax purposes. Here is a list of some of those important factors:
» The location of the individual’s principal residence and whether the residence is owned or rented. If an individual has more than one residence, the courts and tax authorities will look at where the individual keeps their personal belongings, lives with family and intends to live indefinitely.
» Time spent in the new state versus the old state.
» The location of the individual’s spouse and children.
» The state in which the individual’s car is registered.
» The state issuing the individual’s driver’s license.
» Where the individual is registered to vote.
» The location of the individual’s bank accounts.
» The location of the individual’s brokerage accounts and the origination point of the individual’s financial transactions.
» The location of the individual’s health care providers, such as doctors and dentists.
» The location of the individual’s accountants and attorneys.
» The location of a place of worship or social clubs of which the individual is a member.
» The location of real estate.
» The address listed on Form 1040 federal income tax return.
» The location of any safe deposit boxes.
» The state where estate planning documents have been executed (i.e., wills, revocable trust, durable powers of attorney).
Generally, the facts and circumstances based on this list will determine the state with which the individual is most closely associated. The strength of those connections created in the new state will ultimately determine residency for state tax purposes.
Your clients who are considering moving to a new state should have a plan of action to sever connections with their old state. A successful change of residency can save hundreds of thousands or even millions of dollars of combined state income taxes and state death taxes.
Keep in mind that no matter in which state your client is seeking to establish residency for state tax purposes, federal income taxes will still be due and payable on their retirement benefits. And gross estates in excess of the federal exemption amount will still have federal estate taxes due and payable no matter where their assets and property are located in the U.S.